Throughout January, there has been much excitement in the main stream media about the state of the government finances.  Apparently the ‘bond vigilantes’, by reducing the amount they were prepared to pay for a government bond, were expressing their displeasure with proposed government policies.  We were told that Reeves was ‘all out of money’ and would likely have to introduce austerity measures.

No political party has a sensible position on the national debt.  The main political parties, Labour, the Conservatives and the Liberal Democrats, have long said that the economics of the government is no different to the economics of a household, that if a government wants to spend more than it raises in taxes then it must borrow from the private sector.  

The parties challenging the two main political parties, like Reform from the right and the Workers Party and the Green Party from the left, have never contested this view of how a government finances the implementation of its policies.  All political parties are in agreement that national debt is a bad thing.

First let us be clear what the national debt is.  It is the difference between what the government has spent into the economy and what it has taxed out.  In any particular financial year, if a government spends more into the economy than it taxes out then it is said to have a fiscal deficit in that year and the national debt increases.

How can a government spend more than it raises in taxes? We are told it must borrow from the private sector by issuing bonds.  This is incorrect and completely confuses the order in which spending and ‘borrowing’ happens in the UK economy.  The correct order is as follows:

A government gets parliamentary approval for its spending plans.

The Bank of England (BoE) is then, by law, required to make available to the government whatever money is required to finance expenditure approved by Parliament.  The BoE creates the money and puts it into the government account.

The government spends that money into the economy.  The private sector is now richer by that amount.

The Debt Management Office (DMO), which is an agency of the Treasury, calculates the difference between government spending and taxes levied and issues UK government bonds, called gilts, the value of which broadly matches that difference.

 The private sector can then buy these gilts.

It is important to note the sequence here.  The government spending happens before bonds are issued and is not dependent on the issuing of bonds.  Issuing bonds is presented by the main stream media (MSM) as the government borrowing from the private sector in order to finance its spending.  In the MSM account, the markets are seen to have the power to cancel parliament’s spending plans if they do not like them, by not buying issued bonds.  

In fact the opposite is happening.  The government spends into the economy first and then issues bonds which allow the private sector to put its newly acquired wealth (due to the government spending) into a riskless, interest earning asset.  The private sector is not doing the government a favour by buying the bonds and so allowing the government to implement its parliamentary approved program.  On the contrary, it is the government that is doing the private sector a favour by allowing them to save part of their new wealth into riskless, interest earning government bonds.  

The UK government never borrows sterling from the private sector since the UK government is the monopoly issuer of sterling.  The Covid period made this very clear.  National debt increased by some £400 billion.  There was no problem about finding the money.  It was all created by the BoE and the increase in national debt was largely held by the BoE.

Since there is never any possibility that the UK government will be unable to make payments on the bonds that it has issued, what determines the price at which these bonds will be bought?

Before 1985, the government offered bonds ‘on tap’.  That is to say the bonds were available for the markets to buy as and when it suited them.  Money paid to the government to buy bonds was used to reduce the government’s debt with the BoE. If the market did not buy the bonds then the debt was left with the Bank of England in an account known as the ‘Ways and Means account’.  From 1985 onwards, it was decided to move to a full funding rule. 

A full funding rule means that the total value of bonds sold must equal the difference between government spending and taxes levied.  To achieve this result bonds were now auctioned and the markets determined the price at which bonds were bought and, by implication, the effective rate of interest, called the yield.  Thus a bond with an interest rate of 4%  that would mature with a value of £100 might be bought for less than £100, say £98, thus increasing the yield, since the owner of the bond would get £4 per annum on a £98 investment.

The main stream media get very excited when the yield on government bonds increases.  There is talk that the markets are worried that the government might default on its debt.  This is nonsense.  The markets have no such fear.  They are simply trying to maximise their profits.  The price that the markets are prepared to pay for a government bond is closely related to another important change introduced by the BoE in 2009.  

In 2009 the BoE decided to pay interest on the cash that commercial banks hold in their accounts at the BoE (known as reserve accounts).  Government bonds can only be bought by using money held in these reserve accounts.  The markets, therefore, will not buy bonds at a price that will earn them less interest than they would get by simply leaving their money in their reserve accounts.

In January, because of a brief change in inflation expectations, the markets decided a higher yield on government bonds would be required to match what they could expect to earn by leaving their money in their BoE reserve accounts.  The main stream media, desperate, as always, for some excitement, painted this as a judgement by the ‘bond vigilantes’ on Reeves’ economic policy.  It was nothing of the sort.  It was a simple bit of profit maximization that could have been ignored were it not for the fact that Reeves has fiscal rules.

Reeves only has debt and interest problems because she has self-imposed fiscal rules which are pre-occupied with the size of the national debt.  That follows from her claim that a government budget is the same as a household budget and her denial that the UK state is a currency creating state.  She is therefore locked into dealing with a false problem.  The false problem is:  Where will the money come from?  The real problem is: Should the state be actively involved in the economy, and use its currency creating powers to facilitate this?  Labour’s answer is No, all the government can and should do is facilitate the private sector by deregulating yet more.  This is also the position of the Tories and of Reform.  A real Labour government would answer Yes.

Reeves has often repeated her mantra ‘if we cannot afford it, it cannot be done’.  This gives the left a perfect opening to challenge Reeves’ economics. That mantra should be directly challenged with Keynes’ mantra that ‘if it can be done, it can be paid for’.  There are 5 years until the next general election.  That’s 5 years to establish the idea that money is not the problem, that resources, workers and raw materials, are the problem.  

Whenever Reeves cancels an investment project because it cannot be afforded, her whole framing of the problem should be challenged.    Reeves should be asked, are the resources for the project, like building the 40 hospitals needed by the NHS, available to be hired by the government?  If they are, why is she not buying them?  If they are not, how does she propose to get them?  If left wing parties  don’t challenge Reeves’ framing of the problem, they will be much less effective in opposing the austerity that she might propose.